Understanding
Stock Options Trading
and Technical Analysis Basics

Short Butterfly Option Strategy

The Butterfly option strategy is an option position that is composed of 2 vertical spreads that have a common strike price. In other words, the Butterfly strategy involves an opening position where options (either calls or puts) are bought (or sold) at 3 different strike prices. The way in which these options are created makes the butterfly a position that has both limited losses and limited profits.

The Short Butterfly strategy can be created using either all call options or all put options. Due to put-call parity, a Short Butterfly created using call options will behave like one created using put options. In other words, it doesn't really matter whether you use calls or puts to create your Butterfly. Our example here will focus on the version using call options.

The Short Butterfly can be created by selling an In-the-Money (ITM) call option, buying 2 At-the-Money (ATM) call options and selling another Out-of-the-Money (OTM) call option. This is actually a combination of 2 opposing vertical spread options, hence why the butterfly is also known as the Butterfly Spread.

Short Butterfly - Sell 1 ITM Call, Buy 2 ATM Calls, Sell 1 OTM Call
Short Butterfly - Sell 1 ITM Call, Buy 2 ATM Calls, Sell 1 OTM Call

If the stock price falls, you will receive your maximum limited profits (which is the initial credit premium you received when opening the Short Butterfly position). Similarly, when the stock price climbs, you will also receive limited profit. However, if the stock price doesn't change much, you will face a loss, though that loss is limited as well.

As can be seen from the above description, the Short Butterfly is meant to be a strategy that is high in volatility but neutral in direction (ie. you expect the stock to move a lot, but do not know in which direction). As a side note, this might not be the best strategy for you if you are indeed expecting high volatility and are uncertain in stock price direction. Both the Straddle and the Strangle strategies have the same lean towards high volatility and neutral direction, but with the extra benefit that they have the potential for unlimited profit. However, the benefit of the Short Butterfly is that it is a credit position where you pocket the initial premium when creating it.

Summary:

The Short Butterfly option strategy involves selling an ITM call, buying 2 ATM calls and selling an OTM call. It is a strategy that is high in volatility but neutral in position. It is a credit position. You make limited profit if the stock climbs or falls. You incur losses if the stock doesn't move much.

The Long Butterfly spread option is the opposite of the Short Butterfly. The spreads are reversed, and the strategy is used for neutral non-volatile stocks.

One warning about both the Long and Short butterfly strategies: these positions involve buying and selling options at 3 strike prices. For most option brokers, this means you will be paying 3 commissions to open the position, and another 3 commissions to close it. You will need to consider these extra commissions (which differ from broker to broker) when trying to determine if the Butterfly will be profitable for your circumstances.